Wednesday, 19 June 2013

Hoping for a Bank hold-up...

This morning saw the release of the Bank of England's Monetary Policy Committee (MPC) minutes from their 5th and 6th June meeting.  It was Sir Mervyn King's last meeting as governor and so marks an opportunity for the new broom (former Bank of Canada governor Mark Carney) to change the MPC's course.  Investors have generally been positioning themselves for a new era of dovishness as befits Mr Carney's reputation but we believe that more quantitative easing (QE) would not be a good thing for the UK economy (as discussed in Avoiding the Q(E) at the bank), so we hope that policy remains on hold.  The general flow of data has supported that view, giving the pound a much-needed lift.
Bank of England. Image: Adrian Pingston

The UK economy is driven by consumption.  Consumption, however suffers when the pound falls and  household non-discretionary spending costs rise (i.e. petrol, gas, food etc) which reduces the amount left for discretionary consumption. That's not to say we don't wish the UK could rediscover itself as a manufacturing and export powerhouse. Sadly, however, it takes time for the industrial make-up of a country to re-orientate itself and so our export dream has to remain a long-term goal.  In pursuit of that dream, the weakness of wage growth (a factor currently worrying the MPC), makes UK industry more competitive, but higher economic growth (even if driven by consumption) would give entrepreneurs the confidence they need to invest and take advantage of lower cost labour.

The weakness of investment brings us to today's data releases. The Bank of England minutes revealed the persistent 6:3 split amongst the committee against the idea of further quantitative easing.  The minutes do however express some serious concern about the sustainability of the current recovery. One of the factors they draw attention to is the weakness of investment across most business sectors.  There is no question investment has been weak and a lot of that has to do with the fact that general growth is weak. The Bank of England's agents, however, conducted a survey of defined benefit pensions schemes and found that around half of the surveyed companies reported that their deficits were having a negative impact on their investment decisions.

These deficits are impacted by quantitative easing in several ways. Broadly speaking, QE forces down government bond yields while (arguably) driving up the values of other investments.  For pension funds, which have to estimate the value of the liabilities they face in future decades, the present value of those liabilities is discounted by high quality bond yields - therefore the lower bond yields go, the larger their liabilities become. In this way, QE creates accounting holes on balance sheets and the current stance of the pensions regulator is that they should be filled as fast as the employer can reasonably afford.

Again, we believe that, unless borrowing costs for firms were to become prohibitive, more QE actively discourages further investment and restrains growth and may even prevent the longed-for rebalancing of the UK economy.  The counter argument is that the other assets which pension funds have will benefit from QE.

"Pension schemes could, of course, invest in other firms, who could in turn use the funds for capital spending, potentially offsetting some of the negative impact on investment reported in this survey."
Agent's summary of business conditions - June 2013, Bank of England

That seems like wishful thinking to us.  First of all, the valuations of equities look quite reasonable as investors whose preferred habitat is bonds have been reluctant to be forced into the equity market. Furthermore, this counts double for pension funds.  Schemes are penalised for holding higher risk assets through higher contributions to the Pension Protection Fund (PPF).  This means that schemes must pay a higher contribution to the fund (or PPF levy) if they hold equities than they would if they held safe, but low yielding, government UK bonds.

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